Bill Gross Calls it “Shadow Banking System”

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And here’s something else to worry about. Bill Gross, head of PIMCO, the world’s biggest bond fund, calls it the “shadow banking system.” He’s referring to the way money and credit fly around the globe, courtesy of the very same “sophisticated” and “free” institutions that created such prosperity for so many people in the financial industry.

Banks recognize that not all their loans will be repaid. They operate on margins of safety, with reserves set aside for when things go wrong. But in the worlds of swaps, hedge funds and derivatives…slick operators can invest billions with no margins of safety…and no reserves. The result, Gross says, could be catastrophic:

“But today’s banking system, as pointed out in recent Investment Outlooks , has morphed into something entirely different and inherently more risky. Our modern shadow banking system craftily dodges the reserve requirements of traditional institutions and promotes a chain letter, pyramid scheme of leverage, based in many cases on no reserve cushion whatsoever. Financial derivatives of all descriptions are involved but credit default swaps (CDS) are perhaps the most egregious offenders. While margin does flow periodically to balance both party’s accounts, the conduits that hold CDS contracts are in effect non-regulated banks, much like their hedge fund brethren, with no requirements to hold reserves against a significant ‘black swan’ run that might break them.

“According to the Bank for International Settlements (BIS), CDS totaling $43 trillion were outstanding at year end 2007, more than half the size of the entire asset base of the global banking system. Total derivatives amount to over $500 trillion, many of them finding their way onto the balance sheets of SIVs, CDOs and other conduits of their ilk comprising the Frankensteinian levered body of shadow banks.”

Bill Bonner
The Daily Reckoning Australia

Bill Bonner

Bill Bonner

Best-selling investment author Bill Bonner is the founder and president of Agora Publishing, one of the world's most successful consumer newsletter companies. Owner of both Fleet Street Publications and MoneyWeek magazine in the UK, he is also author of the free daily e-mail The Daily Reckoning.
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5 Comments on "Bill Gross Calls it “Shadow Banking System”"

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kayle
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Wait. Wasn’t this the same guy who was hollering for a housing bailout just a few short months ago? http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2007/IO+September+2007.htm “Why is it possible to rescue corrupt S&L buccaneers in the early 1990s and provide guidance to levered Wall Street investment bankers during the 1998 LTCM crisis, yet throw 2,000,000 homeowners to the wolves in 2007? If we can bail out Chrysler, why can’t we support the American homeowner? The time has come to acknowledge that there are precedents aplenty in the long and even recent history of American policy making. This rescue, which admittedly might bail out speculators who… Read more »
Coffee Addict
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Re:CDS swaps —The holding company is most often a regulated bank. The bank typically sets up a separate corpotate entity to issue CDOs based on CDS. My view is that the risk for these instuments is in the medium range. I expect that whie some spectacular losses will make the headlines, the vast majority of these debts will indeed be repaid (in Australia at least). With the market and it’s commentators following the mob downwards, my usually bearish comments are starting to sound bullish (well at least to me). As I mow sit with my super in the cash asset… Read more »
kayle
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Hey Coffee Addict: I’m quite new to this stuff, so bear with me if you’re less concerned about it than I am…I don’t trust much coming from the big banks these days. (And yes, I’ve gotten comfy in the tinfoil hat lately.) :-) As the US is discovering, CDS are only as good as the protection seller that writes them. Ted Seides writes: “Banks claim to run hedged books, effectively serving as a market-maker in the CDS market. As should be evident from the events in subprime, even the most sophisticated systems are often unable to fully hedge risks of… Read more »
Coffee Addict
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Hi Kayle My CDS comments relate to Australia. While the economy here continues to be pushed along by a resources boom, the risk of corporate defaults exceeding 4-6% (over the life of an instrument) remains reasonably low. Beyond the 4-6% level I understand that the equity tranches will be eaten away and mezzanine investors will start to get burnt. CDS based CDO’s in Australia tend to have little (if any) overseas exposure and are issued through banks such as Lehmann, Citibank, AMN Amro, ANZ. The Banks tend to set up separate incorprated entities to manage the funds. Banks potential liability… Read more »
William Boeder
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At this stage, only the Banks and a couple of masterful hood-winkers could know of the intricate labyrinthian “pathway to value” among the many obscure financial instruments being touted lately, just have a gander at the “good stuff” now coming to light: in their being sold, hired, borrowed against, lent to others, security toward, ably converted to, assumed by others, yet somehow a legally tenacious tenable trading instrument? Such as these convoluted guess-hole bits of paper seemed to be freely available for money dealings and I guess, were happily approved of by Glenn Stevens and his head-nodders busily toiling in… Read more »
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